New accounting standards threaten some insurance products

The new International Financial Reporting Standards (IFRS) may cause upheaval in the life insurance industry that includes putting some insurance products and generous guarantees on the endangered list.With the first phase standards scheduled to take effect on Jan. 1, 2011, insurers' accounting has already reached a turning point. Insurers will present all their 2010 quarterly results in the IFRS format, along with the information in their 2009 annual report, to allow comparisons as of 2011.

The second phase of the implementation of IFRS, foreseen for 2013, is making insurers even more anxious. As it stands, they must treat their future commitments toward insured as if they were being honoured today. Insurers fear that the new standards will force them to publish financial results that could needlessly alarm their shareholders and stock markets. This situation would inevitably erode the profitability of guaranteed long-term products such as whole life insurance or level cost universal life.

The International Accounting Standards Board (IASB) is the organization in charge of developing new financial reporting standards that will gradually replace the generally accepted accounting principles in the production of financial statements and results for all exchange-listed companies in Canada (see inset text on page 29). The IASB's website describes the standards already in place, along with upcoming steps and ongoing projects involving standards in development (see www.iasb.org).

If the International Accounting Standards Board (IASB) sticks to its intentions stated in the exposure draft that it plans to publish in April, insurers must recognize their liabilities at fair value (often called market value). They must also use a risk-free interest rate to calculate their reserves. These provisions will effectively introduce exceptional volatility in the results insurers present. The problem is very complex because the concept of market value overlaps several IFRS.

The IASB points out that its proposed definition of fair value is based on exit price, not liquidation values. Liquidation values imply an immediate transaction in which the seller is forced to sell the asset immediately, which affects the price it can earn. In contrast, the exit price is the best possible price for an arm's length transaction in the normal course of business between knowledgeable, willing parties (market participants).

Adjusting results

Insurers are already shaving their profitability margins to adjust their results accordingly. They expect to have to reconfigure their products, raise prices or even drop them altogether. These fears mainly concern products that offer long-term guarantees, such as whole life insurance.

Some insurers are apprehensive about the exposure draft that the IASB plans to release in April, which will recommend the final format of phase II of the IFRS. The IASB will then solicit the last round of briefs and recommendations before adopting a definitive format for phase II.

Simon Curtis, Executive Vice President and Chief Actuary at Manulife Financial, is an IFRS expert who is very close to the heart of the action. Back In 2008, he predicted that phase II of the IFRS would set the industry back. Mr. Curtis refused to grant The Insurance and Investment Journal an interview on this subject, but sources report that his opinion has not changed since his presentation to the members of the Canadian Institute of Actuaries in September 2008, when he said that the "current phase II proposals are considered a step backwards in a number of areas."

Main concern

The most important setback, he pointed out, is that IFRS dissociate the valuation of assets and liabilities. This is a clear break from the valuation method commonly used in Canada up to now. In the currently used Canadian Asset-Liability Management (CALM) method, the insurer's assets and liabilities are intimately linked. The liabilities of a policy correspond to the value of the assets of which the inflows of cash are sufficient to offset the flow of future obligations toward insured, he explains.

The Canadian Life and Health Insurance Association (CLHIA) agrees. "The big worry is the rather dramatic change in the way policy liabilities are determined for insurance contracts," Steve Easson, Vice President Capital, Pension and Taxation told The Insurance and Investment Journal.

"Liability earnings will be determined essentially on their own, without reference to the assets," Mr Easson says.

"Based on the current status of some of the position papers, it appears that there's going to be higher policy liabilities and potentially far more earning volatility. Part of the issue is that exact specifics of the phase II accounting are still not known at this time, he continues.

If the IASB does not budge from its exposure draft of 2010, the CLHIA will try to sway the organization by submitting a brief, he added.

Yvon Charest's position on phase II is also well known. In spring 2009, the CEO of Industrial Alliance publicly decried the lack of perspective of regulators in charge of implementing the IFRS. Imposing valuation at market value on insurers could create large fluctuations in financial results that are totally unrelated to their capacity to generate earnings, he argued.

After giving a speech in Montreal in December, Mr. Charest told The Insurance and Investment Journal that he still had the same reservations about the IFRS. "Given that the Canadian financial sector has resisted the [market] crisis much better than the United States and Europe, we wonder why we have to change accounting rules that have functioned well up to now. The nature of Canadian life insurance products is different from those elsewhere in the world. Our products offer more long-term guarantees. If phase II is applied as is, these products will surely have to change," Mr. Charest explains.

Senior Vice President and Chief Actuary at Industrial Alliance, Denis Ricard, firmly supported his president's position at a later interview. He compares phase II to a "new dogma that encourages accountants to look at the balance sheet without considering the way in which insurers' profits are distributed over time."

Future IFRS will require that insurers record the balance sheet elements at present day value, Mr. Ricard continues. The earnings will then be the gap between this theoretical value and that of the balance sheet during the last valuation period. "Regardless of all the unusual volatility between the two periods and applicable interest rates during the quarter, this method does not take this into account and may cause earnings to vary. These standards do not recognize the long-term nature of our industry. They emphasize the short term," he says.

Mr. Ricard adds that Industrial Alliance reported net earnings of $60 million in the third quarter. According to the IFRS, it should have stated net earnings ranging from ($50 million) to $150 million.New approach

The new approach is problematic because it separates assets and liabilities, but both are closely linked for insurers, Mr. Ricard explains. "Assets and liabilities will be recognized at market value by assuming there's always a market for everything, which is not the case. For example, the last crisis froze the market for corporate bonds, which weigh heavily in insurers' assets. We couldn't sell them."

In contrast, insurers' liabilities largely consist of long-term government and corporate bonds. IFRS do not take into account the fact that insurers hold these instruments as liabilities over the longer term.

"If I hold long-term Canada bonds in my liabilities and short-term corporate bonds, real estate and equity in my assets, the market value of the assets may change sharply compared with that of liabilities. Also, the value of liabilities may decrease due to interest-rate fluctuations while the assets remain stable. This causes great volatility. Under these conditions, how can we opt to value an actuarial reserve at a specific date, even though I will only pay out the amounts insured in 50 years?" Mr. Ricard continues.

Mr. Easson, of the CLHIA, warns that IFRS will affect the industry in their present form. "The potential results will be rising prices or withdrawal of products. It may impair the ability to offer long [term] guaranteed products," he says.

Mr. Ricard predicts that IFRS will have a major social impact. "These products will become so expensive that insurers will opt to offer fewer guarantees or go back to participating products with adjustable premiums."

At the presentation of Manulife's Q3 results for 2009, CEO Donald Guloein was grilled by an analyst about IFRS. He did not hide his anxiety about some of the IASB's proposals, including the discounting of all actuarial reserves at a risk-free interest rate. "That would not be a very bright thing to do. The consequence of that would mean that people around the world would not be able to buy any products with any long-term guarantees at all," he said at the conference on Nov. 5, transcribed by Thomson Reuters.

Mr. Guloein sees guaranteed insurance products such as lifetime annuities as the last safe bastion for retirement savings, given the decline of government and employer-sponsored pension plans. "If everybody discounted everything at the risk-free rate you can imagine what that would do to pension plans around the world. But it's not (only) our company or our country, it's a number of companies around the world; very large and sophisticated companies. And it's also some governments that are saying we have to intervene on this stuff to make sure it lands in a sensible place," he points out.

AXA Assurances closed its segregated fund in the fall due to the effects of the economic crisis, not IFRS (see The Insurance Journal, October 2009). However, the company sees the coming of the IFRS as potentially even more damaging than the financial crisis.

"The withdrawals and changes that we have seen in the segregated fund sector in Canada are a glimpse of what the arrival of IFRS might bring. The same thing may happen in life insurance. Because of phase II of the IFRS, guaranteed product pricing may be revised upward and offerings restructured," Robert Landry, the company's Executive Vice President, life insurance and financial services, told The Insurance and Investment Journal in late 2009, mentioning whole life and level cost universal life. He explains that the IFRS were introduced a while ago, but the financial crisis has brought to light problems in their application.Employee benefits

Sylvie Raymond, Vice President, Finance and Compliance Officer at AXA, also points the finger at the phase I standard that might complicate things for insurers, among others. Standard IAS 19, which concerns employee benefits, will affect all public companies regardless of sector. For one, it may have a negative impact on their retained earnings. The standard requires companies to state in the balance sheet the full amount of any actuarial deficit that exceeds 10% of the real value of the obligations of a fixed benefit plan. Actuarial gains and loses must be recognized immediately in the statement of income. Even though it is part of phase I, the standard will only take effect in 2013.

"We are also afraid that the new standards will bloat the financial reports with details which will overwhelm the uninitiated reader," Ms. Raymond adds. The IFRS will require each sector of a company to be covered in a distinct section of the report.

Ms. Raymond did find a silver lining in the IFRS. "Capital requirements are very strict in Canada unlike in other countries. Today, this is a disadvantage for us in terms of competitiveness. IFRS allow us to compare a Canadian company and a foreign company on the same footing."